In the World

An unanticipated escalation in global trade tensions precipitated a sell-off across risk assets. After the latest round of trade talks with China hit an impasse, President Trump announced an increase in tariffs from 10% to 25% on $200 billion in Chinese goods; he also signed an executive order barring U.S. companies from conducting business with the controversial Chinese telecommunications company Huawei, among others. China retaliated by hiking tariffs on $60 billion in U.S. goods and threatening to tax rare earth metals, a move that could stunt U.S. technology growth. The global trade war then opened on a new front after the U.S. administration surprised markets by announcing it would impose a 5% tariff on all Mexican imports – set to rise by 5% each month, up to 25% ­– unless Mexico helped stem the flow of illegal immigration into the U.S. Risk assets globally reversed course as developed market equities1 fell 5.8%, marking their first negative month this year, while emerging market (EM) equities2 fell 7.3% on the month as dollar strength exacerbated the trade concerns. Not surprisingly, the Chinese yuan and Mexican peso were the worst-performing EM currencies against the U.S. dollar in the month. Credit markets weren’t immune to the pullback in risk appetite either: Spreads broadly widened, with high yield spreads3 75 basis points (bps) wider. As risk assets sold off, bond yields fell sharply across the yield curve, leaving U.S. 10-year yields 38 bps lower at 2.12%, their lowest level since 2017. The front end of the yield curve also inverted for the second time this year as the spread between three-month and 10-year yields turned negative.

Signs of decelerating global growth also weighed on market sentiment. Manufacturing metrics in particular dipped lower across regions as purchasing managers’ indexes (PMIs) in Japan, Europe, and China fell below 50 (the level separating contractionary activity from expansionary), while the U.S. index – though still above 50 – fell over two points to its lowest level in nearly a decade. Other economic data in China also pointed to weakness despite recent stimulus measures, highlighted by slowing retail sales and a larger-than-expected decline in industrial production. With global inflation pressures still subdued, central banks remained supportive: New Zealand’s central bank became the latest developed economy to ease policy, cutting rates to a record low of 1.5%, in light of unexpected weakness in inflation. Even Federal Reserve members suggested that rates could be lowered if data were to show persistently below-target inflation or materially weaker global conditions.

Outside of trade, May featured a number of election-related headlines. In the U.K., Prime Minister Theresa May announced that she would step down after political pressure arising from her failure to pass a Brexit deal. Meanwhile, a number of incumbents will remain in office: Australian Prime Minister Scott Morrison secured a third term for his center-right government in a surprise victory, and India’s Prime Minister Narendra Modi handily won his re-election. The European Parliament elections revealed few surprises, with populist and eurosceptic parties picking up support broadly in line with predictions, though remaining well below 50% and thus limited in their power. The Brexit Party in the U.K. finished first, with 31% of the vote; Deputy Prime Minister Matteo Salvini’s League Party solidified its power in Italy, while its coalition partner, the Five-Star Movement, saw its popularity wane; and Marine Le Pen’s National Rally Party finished ahead of President Emmanuel Macron’s pro-EU party in France. In the U.S., the Trump administration delayed tougher sanctions on Iran’s petrochemical sector in hopes of easing growing tensions between the two countries after the U.S. accused Iran of attacking Saudi Arabian oil tankers.

1 MSCI World Index
2 MSCI EM Index
3 Bloomberg Barclays US High Yield 3% Issuer Cap Index

 

Monthly Market Update

Together Again … and Headed Down
U.S. equities tumbled in May, marking the first monthly decline of 2019 and a reversal of the robust risk appetite that had underpinned impressive gains in equities through April. A repricing of global trade tensions and lingering growth concerns dragged risk assets into the red, with the S&P 500 dropping 6.4% in the month. Consistent with traditional “risk-off” behavior, bonds rallied as global rates fell dramatically: The 10-year U.S. Treasury yield declined 38 bps to 2.12% (notably below the Federal Reserve’s current policy range of 2.25%−2.50%). That is the lowest level since 2017 and more than 100 bps below the 2018 high reached last November. The unusually large move lower in yields is partly due to investors’ rising expectations for interest rate cuts by the Fed, which increased to three by the end of this year. As a result, the U.S. yield curve inverted again (typically seen as a precursor to recession), adding to fears of deteriorating economic conditions.

In the Markets

EQUITIES

Escalating U.S.-China tensions in May stalled the recovery in developed market equities.  Stocks1 declined 5.8% and cyclical sectors underperformed defensive shares. U.S. equities2 fell 6.4% as mixed economic data also weighed on investors. European equities3 declined 4.9%, and Japanese equities4 fell 7.4% on the deteriorating outlook for global growth and trade, even as the yen strengthened on “safe-haven” demand.

Emerging market equities5 declined 7.3% overall in May, but performance across individual markets varied significantly. Chinese equities7 fell 5.6% as sluggish economic data and escalating trade tensions led to a sharp increase in volatility. By contrast, Indian stocks8 increased 1.9% in conjunction with the sweeping victory of Prime Minister Narendra Modi and his party, the National Democratic Alliance, in the general election. Despite a drop in oil prices, Russian equities9 also rallied 4.7% after a dividend hike announcement from Gazprom spurred global investor interest in discounted local market stocks. And finally, in Brazil, stocks6 rose 0.7% thanks to positive developments regarding pension reform and improving public sentiment toward the government.

Equity markets

DEVELOPED MARKET DEBT

Developed market bond yields broadly fell, and yield curves generally flattened in May as escalating trade tensions and weaker fundamental data weighed on risk sentiment. The U.S. 10-year Treasury yield fell 38 basis points (bps) to 2.12%, and the yield curve inverted more noticeably, with the 10-year yield dropping further below the three-month rate: The yield spread reached its widest negative level since 2007. In the U.K., another round of Brexit developments contributed to the decline in yields; the 10-year U.K. gilt yield fell 30 bps to 0.89%. Similarly, the 10-year German Bund fell 22 bps to a new low of -0.20% and the 10-year rate in Japan dropped 5 bps to -0.09%. On the monetary policy front, the Reserve Bank of New Zealand became the latest central bank to cut policy rates alongside slower growth and below-target inflation.

Developed market bond markets

INFLATION-LINKED DEBT

Generally perceived as a safe haven, global inflation-linked bonds (ILB) posted positive absolute returns across most countries in May when global trade concerns re-emerged. Linkers underperformed their nominal bond counterparts, however, as risk-off sentiment and a plunge in oil prices put pressure on inflation expectations. U.S. TIPS absolute returns were strong, and the real yield curve bull-flattened on the expectation of Federal Reserve rate cuts amid weakening global growth and increased market uncertainty. Breakeven inflation (BEI) rates10  in the U.S. dipped sharply lower in concert with the energy markets; weaker inflation readings and the Fed’s assessment that the weakness was “transitory” put further pressure on expectations. U.K. linkers rallied sharply in May and, breaking from the global trend of weaker inflation expectations, breakevens surged when cross-party Brexit negotiations stalled and European Parliament elections highlighted a divided population.

Inflation-linked bond markets

CREDIT

Global investment grade credit11 spreads widened 15 bps in May as global trade tensions escalated. The sector returned 1.14%, underperforming like-duration global government bonds by 1%. Trade-dependent industries, such as gaming, automotive, and metals and mining, led the underperformance. Energy sectors also declined alongside an 11% drop in crude oil prices. Industries insulated from potential global trade disruptions outperformed the broader market, led by healthcare and REITs.

High yield bonds came under strong pressure in May from falling equity and oil prices, signs of deteriorating growth, and intensifying trade tensions. Global high yield bond12 spreads widened 80 bps. The sector returned
-1.19% for the month, underperforming like-duration Treasuries by 2.47%. The higher-quality BB segment returned -0.64% while the CCC segment returned -2.83%.

Credit markets

EMERGING MARKET DEBT

Emerging market (EM) debt finished the month modestly positive in both subsectors, displaying resilience in a generally volatile month. External debt returned 0.57%13 as a substantial 28-bp widening in spreads was outweighed by a 37-bp move lower in the underlying U.S. Treasury yields.14 Local debt15 posted a return of 0.30%, while a rally in local rates cushioned generally weaker EM currencies versus the U.S. dollar. Despite the relatively strong performance in EM debt, the escalation of trade tensions and resurgence of growth concerns represented a negative turn in the global backdrop that could weigh on EM risk sentiment overall.

Emerging market bond markets

MORTGAGE-BACKED SECURITIES

Agency MBS16 returned 1.29%, underperforming like-duration Treasuries by 40 bps. May was the eighth month with the Fed unwound at $20B, and the Fed has cumulatively sold $240 billion of MBS. MBS lagged their Treasury counterparts in May, but performance was mixed across the coupon stack. Lower coupons materially outperformed higher coupons; Ginnie Mae MBS underperformed Fannie Mae MBS, and 15-year MBS underperformed conventional 30-year MBS. Gross MBS issuance increased 20% to $115 billion, and prepayment speeds increased 24% in April (most recent data). Non-agency residential MBS spreads were flat during May, while non-agency commercial MBS17 returned 2.1%, outperforming like-duration Treasuries by 5 bps.

Mortgage-backed securities markets

MUNICIPAL BONDS

The Bloomberg Barclays Municipal Bond Index returned 1.38% in May, bringing total returns to 4.71% for the year. Munis underperformed the U.S. Treasury index over the month, however, and MMD/UST ratios cheapened across the curve. High yield munis continued to demonstrate strong performance, returning 1.62% for May and outperforming the investment grade muni index. This brought year-to-date returns to 6.11%. High yield performance was driven primarily by positive returns in the tobacco and resource recovery sectors. Total supply of $28 billion in May was 7% higher versus the previous month but down 19% year over year. Muni fund flows remained strong, marking 21 straight weeks of inflows. Investment inflows totaled $7.9 billion in May and $37.3 billion for 2019, still the strongest recorded start to a year.

U.S. municipal bond market

CURRENCIES

The U.S. dollar ended the month modestly stronger (0.3% based on DXY) than developed market counterparts, driven by Fed rhetoric, escalating global trade concerns, and weakness in eurozone fundamentals. The euro was 0.4% weaker versus the dollar as political fragmentation in the European Union elections also weighed on the currency. Despite surprisingly positive economic data, the British pound weakened 3.1% against the dollar due to increasing uncertainty around Brexit following Prime Minister Theresa May’s resignation. The Japanese yen, a traditional “safe-haven” currency, benefited from global trade tensions and strengthened 2.9% against the dollar. Turning to emerging markets, the Chinese yuan was 2.5% weaker versus the dollar on higher trade tensions with the U.S. and lower-than-expected manufacturing PMI reports.

Currency markets

Commodities

Commodities delivered negative returns in May. Despite signs of tightness in the physical market, oil prices fell the most since November 2018 as mounting trade tensions and a continued slowdown in the Chinese economy cast doubt on the outlook for global growth and related demand for oil. In its latest oil market report, the International Energy Agency (IEA) reduced its demand growth forecast for 2019 by 90,000 b/d to 1.3 million b/d, while data from the U.S. Energy Information Administration (EIA) pointed to bloated domestic inventories. Natural gas prices continued to decline amid bearish fundamentals: Strong production and milder weather contributed to higher-than-usual injections at storage facilities. Row crop prices including corn, wheat and, to a lesser extent, soybeans moved sharply higher over the month as exceptionally wet spring weather across the U.S. Midwest significantly delayed planting and spurred concerns over crop quality. According to the May 28 USDA Crop Progress Report, corn planting was just 58% complete compared with the five-year average of 90%. Concerns over the outlook for the global economy also weighed on base metals, while gold benefitted from a flight to quality.

Oil market

Monthly Market Update

Outlook

Based on PIMCO’s cyclical outlook from March 2019.

In the U.S., we continue to expect growth to slow to 2%–2.5% in 2019 from nearly 3% last year. Factors contributing to the deceleration include fading fiscal stimulus, the lagged effect of tighter monetary policy over the past few years, and headwinds from the China/global slowdown. We estimate that China’s easing will not filter through to U.S. growth until late 2019 or early 2020. Headline inflation looks set to drop to 1.5%−2% this year, while core CPI moves sideways. With growth slowing and inflation remaining below target, the Fed is likely to keep rates unchanged in 2019.

For the eurozone, we expect growth to slow to a trend-like pace of 0.75%–1.25% in 2019 from close to 2% in 2018, as weak global trade exerts significant downward pressure on the economy and Italy slipped into recession. An improvement in global trade conditions through this year should contribute to a gradual reacceleration. Reflecting firmer wage growth, we expect a moderate pickup in core inflation, which has been stuck at 1% for some time. In line with the European Central Bank’s (ECB) forward guidance, we expect policy rates to remain unchanged this year. 

In the U.K., we expect real growth in the range of 1%–1.5% in 2019, modestly below trend, and we continue to think that a chaotic no-deal Brexit is a low-probability event. We see core CPI inflation stable at or close to the 2% target as import price pressures have faded and domestic price pressures remain subdued. In the event of a soft Brexit by midyear, a rate hike by the Bank of England in the second half of the year would appear likely.

Japan’s GDP growth is expected to be modest at 0.5%–1% in 2019, broadly unchanged from 0.7% in 2018. With core CPI inflation expected to dip into negative territory (due to temporary factors) around the middle of the year, we expect the Bank of Japan to keep its targets for short rates and the 10-year yield unchanged this year.

In China, we see growth slowing in 2019 to the middle of a 5.5%‒6.5% range from 6.6% in 2018, but stabilizing in the second half of the year as fiscal and monetary stimulus find some traction and a likely trade deal between the U.S. and China supports confidence. We expect fiscal stimulus of 1.5% to 2% of GDP. Inflation remains benign at 1.5%-2.5% in our forecast, and we look for another rate cut by the People’s Bank of China in addition to more reductions in banks’ reserve requirement ratios. Yuan stability is well anchored with a patient Fed and the understanding that this needs to be a component of the China-U.S. trade deal.

FOOTNOTES:

1MSCI World Index, 2S&P 500 Index, 3MSCI Europe Index (MSDEE15N INDEX), 4Nikkei 225 Index (NKY Index), 5MSCI Emerging Markets Index Daily Net TR, 6IBOVESPA Index (IBOV Index), 7Shanghai Composite Index (SHCOMP Index), 8S&P BSE SENSEX Index (SENSEX Index), 9MICEX Index (INDEXCF Index), 10Breakeven Inflation: Market-based measure of expected inflation derived from the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity, 11Bloomberg Barclays Global Aggregate Credit USD Hedged Index,  12BofA Merrill Lynch Developed Markets High Yield Index, Constrained, 13JP Morgan EMBI Global, 14US Treasury 10 YR, 15JP Morgan GBI-EM Global Diversified, 16Bloomerg Barclays Fixed Rate MBS Index (Total Return, Unhedged), 17Bloomberg Barclays Investment Grade Non-Agency MBS Index

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PIMCO Asia Pte Ltd is regulated by the Monetary Authority of Singapore as a holder of a capital markets services license and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax; a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation- Protected Securities (TIPS) are ILBs issued by the U.S. government. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. It is not possible to invest directly in an unmanaged index.


This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2019, PIMCO.

Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise. A low interest rate environment increases this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. Outlook and strategies are subject to change without notice. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2019, PIMCO.